Complex Made Simple

Does the Chinese Yuan’s fall presage an emerging markets crash?

China may have to let its currency devalue to spur economic growth, but that could spell disaster for emerging markets

Chinese GDP growth is now 6%, the lowest since 1990 and the country's economic model faces existential risk Japanese and South Korean shares have been slammed as the yen attracts safe-haven bids. The Chinese renminbi has plunged to near 2008 levels as the Trump White House imposes punitive tariffs on Chinese exports and blacklists Huawei

By Matein Khalid: Chief Investment Officer and Partner at Asas Capital

China faces not just trade protectionism in Washington but an assault on its strategic role as the new power broker of the Pacific Basin. 2019 has witnessed the onset of a new economic Cold War that amplifies geopolitical flashpoints from Taiwan to Sinkiang, Hong Kong to the South China Sea. The financial markets have concluded that China has no choice but to let its currency depreciate in a desperate attempt to preserve a fragile domestic growth rate.

After all, the legitimacy of the Communist Party is based on its track record of delivering 10% annual economic growth rates since the Deng Xiaoping era. Yet Chinese GDP growth is now 6%, the lowest since 1990. The China economic model faces existential risk in the most dangerous moment for its autocrat Red Emperors since the Tiananmen Square massacre of June 1989.

China’s central bank and sovereign wealth funds own 1.3 trillion in US Treasury bills, notes and bonds. China simply cannot afford to play a game of global chicken with Washington by threatening to dump Uncle Sam’s IOU’s in the debt markets.  The US Treasury debt market alone can absorb the sheer scale of China’s financial assets – and the bond markets of Germany and Japan are mired in negative yields. China cannot afford to lose access to the American export market at any cost. The demons of Chinese history – civil wars that lasted generations and slaughtered untold millions, from the Taiping rebellion to the Mao-Nationalist struggle to the Cultural Revolution – could be the endgame of any economic collapse of the Middle Kingdom.

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If the Chinese yuan falls to 7.40, brace for a new spasm of intercontinental contagion in emerging markets. The most vulnerable currencies are those with large current account deficits that make them vulnerable to an exodus of offshore hot money at a time when the IMF has cut its global growth forecast to 3.3%.

The fault lines of a weaker Chinese yuan have reverberated across the dark alleys of global finance. Japanese and South Korean shares have been slammed as the yen attracts safe-haven bids. The Singapore dollar just suffered one of its worst weeks since November 2018. The New Taiwan Dollar has taken an epic hit. US semiconductors are down 16% in 2019. When China sneezes, the Asian Tigers all catch influenza and these economies are the growth epicentre of the global economy.

Something ugly is brewing in the netherworld of emerging market currencies. The Chinese renminbi has plunged to near 2008 levels as the Trump White House imposes punitive tariffs on Chinese exports and blacklists Huawei, the People’s Republic’s crown jewel telecom equipment champion. The fall in the Chinese yuan, in turn, has spread contagion across emerging market currencies and even unnerved the stock markets of Japan, the US and Europe. Volatility has begun to creep higher. As the USS Abraham Lincoln battle carrier group and squadrons of B-52 bombers are deployed to the Middle East, the prospect of a US-Iran military confrontation haunts the chancelleries of the world, a sinister replay of Iraq 2003.

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As in early 2016, China can spread havoc and contagion across the world and well trigger a meltdown in global risk assets. The Peoples Bank of China has let the weaker yuan act as a shock absorber to an economy with 280% debt/GDP ratios whose growth rates, debt markets, shadow banking system, investor confidence, retail sales and export trends show unmistakable metrics of stress. Political and financial shocks of the magnitude Trump White House has inflicted on China invariably result in a plunge in the national currency, as happened in Turkey since last summer and Britain since the June 2016 referendum to leave the EU. Yet China is the world’s second largest economy, its largest exporter, its most populous nation, its most leveraged credit Frankenstein.

President Xi cannot afford the political cost of a recession, a wave of corporate defaults, flight capital and mass job losses in China’s factories. He will not order the People’s Bank of China to raise interest rates to defend the embattled Chinese yuan. So the path of least resistance is to let the yuan’s slide accelerate in global markets.

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Yet this is precisely the scenario that will ignite a new emerging market crisis, just as the flotation of the Thai baht led to the Asian currency meltdown in 1998 and the collapse of the Turkish lira led to the EM carnage of 2018. The sharp falls in Shanghai and Shenzhen demonstrate that foreign investors are fleeing the Mainland’s stock exchanges.

China is now more than 35% of global emerging market indices. Just as US-German trade tensions culminated in Black Monday, the epic stock market crash of October 1987, the free fall in the Chinese yuan’s endgame will be a horrific emerging market crash of autumn 2019.   Since it is insane to expect statesmanship from Trump at the G-20 conclave in Osaka. I remain short emerging markets FX and equities.